IMF Working Paper on Investment

8/2/2019 IMF Working Paper on Investment

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Does the Business Environment Affect

Corporate Investment in India?

Kiichi Tokuoka

WP/12/70


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2012 International Monetary Fund WP/12/70

IMF Working Paper

Asia and Pacific Department

Does the Business Environment Affect Corporate Investment in India?

Prepared by Kiichi Tokuoka

Authorized for distribution by Laura Papi

March 2012

Abstract

Since the global financial crisis, corporate investment has been weak in India. Sluggishcorporate investment would not only moderate growth from the demand side but also

constrain growth from the supply side over time. Against this background, this paper

analyzes the reasons for the slowdown and discusses how India can boost corporateinvestment, using both macro and firm-level micro data. Analysis of macro data indicates

that macroeconomic factors can largely explain corporate investment but that they do notappear to account fully for recent weak performance, suggesting a key role of the business

environment in reviving corporate investment. Analysis of micro panel data suggests that

improving the business environment by reducing costs of doing business, improving financialaccess, and developing infrastructure, could stimulate corporate investment.

JEL Classification Numbers: D22, D24, E22

Keywords: Corporate investment, Business environment, Costs of doing business, Infrastructure

Authors E-Mail Address: [email protected]

This Working Paper should not be reported as representing the views of the IMF.

The views expressed in this Working Paper are those of the author(s) and do not necessarily

represent those of the IMF or IMF policy. Working Papers describe research in progress by the

author(s) and are published to elicit comments and to further debate.


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Contents

I. Introduction ....................................................................................................................3

II. Analysis of Macroeconomic Data ..................................................................................5

III. Analysis of Firm-Level Micro Panel Data .....................................................................7

IV Policy Issues and Conclusions .....................................................................................15

References ................................................................................................................................17

Appendices

A. Regression Results Using Alternative Data Set ...........................................................19

B. Description of Semi-aggregate Data ............................................................................20

Box

1. Studies Utilizing Variability within India ....................................................................14

Figures1. Investment in India ........................................................................................................42. Determinants of Corporate Investment ..........................................................................9

3. Business Environment Indices .....................................................................................11

4. Variability of Business Environment within India ......................................................12

Tables

1. Impact of Macroeconomic Variables on Corporate Investment ....................................6

2. Estimation of Investment Function ................................................................................83. Estimation of Investment Function Using Subsamples .................................................8

4. Regression of Profitability ...........................................................................................135. Estimated Aggregate Impact of Reducing Costs of Doing Business ...........................15


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I. INTRODUCTION

While investment in India was the main growth driver before the global financial crisis,

it has been lackluster since then. Before the global financial crisis, strong corporateinvestment was behind the increase in investment (Figure 1), which was well above levels in

most emerging economies (in percent of GDP). Since 2009, however, corporate investment

has slowed sharply to 10 percent of GDP from 14 percent before the crisis. More recently,the growth of investment (gross fixed capital formation) has slowed to about 0.6 (quarter on

quarter) on average in the first three quarters in 2011, compared with an average of nearly

3 percent between 20002007, and high frequency data on capital goods production suggest

that corporate investment may be weakening further.

This weak corporate investment performance has demand and supply implications. Ifcorporate investment remains as weak as it is now, lower demand would reduce growth

substantially over the medium term. For example, if the quarterly growth rate of corporate

investment stays at percent (the average growth in investment in 2011), lower demandwould reduce medium-term GDP growth to around 7 percent.1 Sluggish corporate investment

would also constrain growth from the supply side over time. This is a particularly relevant

issue for India, as it is a supply-constrained economy.

Views vary on whether macroeconomic or structural factors are responsible for the

recent weak corporate investment. On the one hand, increased macroeconomic uncertaintyincluding from high inflation and the weaker global economic outlook may be weighing on

investor sentiment. At the same time, monetary tightening since early 2010 may have

affected corporate investment at the margin. On the other hand, structural factors, such as thestill unfavorable business environment, weakening governance, and slower government

project approvals, may be depressing investment. Costs of doing business in India remain

among the highest in the world, and according to the World Economic Forum, in recent years

an increasing number of people are concerned about weakening governance in India.

The main message of this paper is that not only macroeconomic factors but also

structural factors, in particular, the business environment, affect corporate investment

in India. As we will see in detail below, macroeconomic factors can largely explaincorporate investment, but they do not appear to account fully for recent weak performance.

While it is not entirely clear how important structural factors are in explaining the recent

weakening of investment, analysis of micro panel data suggests that improving the businessenvironment by reducing the costs of doing business, upgrading the financial system, and

developing infrastructure, could stimulate corporate investment.

This paper is structured as follows. Using macro data, the next section examines to whatextent macroeconomic factors can explain the recent weak corporate investment performance.

Using firm-level micro panel data, Section III discusses what other factors not captured by

1 The analysis in Oura and Topalova (2009) suggests that an increase in corporate sector stress in India (e.g.,

from global deleveraging) could also weaken corporate investment substantially.


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the analysis of macroeconomic data, in particular the business environment, affect corporate

profitability and investment. Section IV discusses policy issues and concludes.

Figure 1. Investment in India

Before the global financial crisis, investment was the main

driver of growth in India

with its share rising substantially compared with other

emerging economies.

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

20 01 20 02 20 03 2 00 4 2 00 5 2 00 6 2 007 20 08

Investment

Private consumption

Other

Real GDP growth (in percent)

Source: IMF WEO database

India: Breakdown of GDP Growth(Contributions, in percent)

10

15

20

25

30

35

40

45

50

10

15

20

25

30

35

40

45

50

2000 2001 2002 2003 2004 2005 2006 2007 2008

India Brazil China Russia ASEAN4

Selected Economies: Investment(In percent of GDP)

Source: IMF WEO database

1/ Investment refers to gross fixed capital formation.

Since the crisis, the share of corporate investment hasfallen

and high frequency production data point to a continuedslowdown in corporate investment as machinery andequipment production has been declining.

0

5

10

15

20

25

30

35

40

45

0

5

10

15

20

25

30

35

40

45

FY2001 FY2005 FY2010 FY2011

Private corporate Public

Household

Total

India: Annual Investment 1/(In percent of GDP)

Source: Haver

1/ Investment refers to gross fixed capital formation. FY20xx refers to a fiscal

year ending in March 20xx.

-20

-10

0

10

20

30

40

50

Jan-2010

Apr-2010

Jul-2010

Oct-

2010

Jan-2011

Apr-2011

Jul-2011

Oct-

2011

C ap it al g oods M ac hine ry and e qu ip me nt

India: Production Growth(3 month average of y/y growth, percent)

Source: Haver

High inflation may be weighing on investor sentiment. In recent quarters, actual investment has been consistentlybelow levels predicted by macroeconomic variables.

-2

0

2

4

6

8

10

12

14

16

18

-2

0

2

46

8

10

12

14

16

18

Jan-2

007

Jul-2007

Jan-2

008

Jul-2008

Jan-2

009

Jul-2009

Jan-2

010

Jul-2010

Jan-2

011

Jul-2011

Consumer price index

Wholesale price index

India: Inflation Rate(In percent, year on year)

Source: Haver.

28

29

30

31

32

33

28

29

30

31

32

33

2008

Q1

Q2 Q3 Q4 2 00 9

Q1

Q2 Q3 Q4 2 010

Q1

Q 2 Q3 Q4 2 011

Q1

Q2 Q3

Actual (4 quarter ma)

Predicted by macro variables (4 quarter ma)

Sources: Haver; IMF WEO database; and staff estimates.

1/ Investment refers to gross fixed capital formation.

India: Quarterly Investment 1/(In percent of GDP)


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II. ANALYSIS OF MACROECONOMIC DATA

A variety of macroeconomic factors affects corporate investment. Domestic and global

economic cycles are likely to affect corporates investment decisions, as marginal returnsfrom corporate investment are likely to be cyclical. High and volatile inflation increases

uncertainty about returns from corporate investment, which may also make corporates

hesitant to undertake investment. Finally, real interest rates have a direct impact on corporateinvestment as they determine financing costs.

To quantify the impact of macroeconomic variables on corporate investment, this paper

estimates the following equation:

CIt = a1 Xt1 + a2 VIXt + a3 CIt1 + t,

where CIis corporate investment (in percent of GDP), andXis a vector of macroeconomic

variables including the volatility of the inflation rate (CPI),2

the inflation rate (CPI), real

GDP growth, the real interest rate,3

and the worlds real GDP growth. The VIXglobal stock

volatility is used to control for global uncertainty, which may affect the level and volatility ofprofit. This paper uses annualdata (FY19922011) because quarterly data on corporate

investment do not exist.

Using annualdata, the estimation results suggest that the volatility and level of inflation

and global uncertainty may depress corporate investment. The coefficient on the

volatility of inflation is consistently negative, and statistically significant in most

specifications (Table 1).4

The coefficients on the real interest rate and global stock volatility

are negative and statistically significant. Other explanatory variables have the expected signsbut are statistically insignificant in most cases.

In terms of contribution to corporate investment, the high and volatile inflation, andhigher global uncertainty are estimated to have contributed negatively between end-

FY2007 and end-FY2011. This is partly offset by the monetary easing after the globalfinancial crisis, and the total net contribution from these macroeconomic factors during this

period is estimated at around 1.3 percent of GDP (Table 1). The negative coefficient on (the

lag of) the real interest rate also suggests that monetary tightening since early 2010 may havehit corporate investment during FY2012 (April 2011March 2012), but the analysis of annual

data does not say much about factors behind the weak corporate investment in recent

quarters.

2 The volatility of the inflation rate is calculated by the standard deviation of monthly inflation rates (month onmonth, seasonally adjusted) in the year.

3 For the real interest rate, this paper uses the average of nominal prime lending rates of ICICI Bank and IDBIBank (whose data on prime lending rates are available for over 20 years) deflated by CPI inflation.

4 Using WPI (wholesale price index) instead of CPI gives a negative coefficient on the volatility of the inflationrate, but the coefficient is not significant.


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Table 1. Impact of Macroeconomic Variables on Corporate Investment 1/

Dependent variable:

corporate investment (% of GDP)(1) (2) (3)

between

end-FY07 and

end-FY11

lag of volatility of inflation rate -2.79* -2.62* -1.59 -0.71

(1.32) (1.31) (1.08)

lag of inflation rate -0.11 -0.051 -0.21* -1.74

(0.16) (0.17) (0.11)

lag of real GDP growth 0.10 0.14 -0.03

(0.22) (0.17)

lag of real GDP growth ex agriculture 0.28

(0.32)

lag of real interest rate -0.51** -0.45* -0.34* 1.66

(0.22) (0.23) (0.17)lag of world's real GDP growth 0.36 0.37

(0.31) (0.31)

global stock volatility -0.11*** -0.49

(0.035)

l ag of corporate inve stme nt (i n % of GDP) 0.65*** 0.55** 0.85***

(0.19) (0.23) (0.14)

Total

-1.3

1/ *** p


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The analysis ofquarterly data indicates that while investment can be largely explained

by standard macro variables, since late 2010 it has been falling short of levels predicted

by these variables somewhat (bottom right chart of Figure 1). These results hint that recent

weak investment may also be reflecting factors that are not fully captured by standard

macroeconomic variables, such as factors that affect the business environment.

III. ANALYSIS OF FIRM-LEVEL MICRO PANEL DATA

The analysis of micro panel data helps identify determinants of corporate investment,

which are difficult to detect using macro data. For example, the impact of aggregate costsof doing business on corporate investment may be difficult to identify, given their limited

time variation. Following Nabar and Syeds (2011), this paper begins by estimating the

standard investment function using Indian firm-level panel data:

ij,t/kj,t= a1 profitabilityj,t1 + a2 liquidityj,t1 + a3 leveragej,t1 + a4 ij,t1/kj,t1 + control vars + j,t,

wherej denotes firms, tdenotes years, i is corporate capital investment, kis the stock of

capital,profitability is Tobins q, liquidity is the ratio of liquid assets to capital k,7leverage isthe ratio of debt to total assets, and the stock price volatility of each firm and time dummies

are included as control variables. The main estimation method is the ArellanoBondDynamic Panel GMM Estimator (Dynamic GMM), which implements GMM after taking

first differences. The data are from Prowess provided by the Centre for Monitoring Indian

Economy (CMIE). Prowess is a data set that reports both listed and unlisted companies dataand has a panel structure.8 After standard sample selection and restricting the sample to

nonfinancial companies, the sample includes 12,306 observations (2,291 companies) over

19902011.

The results confirm that profitability, liquidity, and leverage are key determinants of

corporate investment in India. Table 2 shows that the coefficients on profitability andliquidity are positive and generally significant, while the coefficient on leverage is negative

and significant. One might think that the impact of liquidity may differ by sector or firm

size,9 but the results in Table 3 do not support this hypothesis. The coefficient on liquidity,interacted with the manufacturing dummy, the firm size dummy, or the exporter dummy is

statistically insignificant (3rd

, 6th

, and 9th

columns of the table). The positive coefficients onliquidity in Tables 2 and 3 suggest that there remains room for improving financial access, as

in a world of perfect financial markets, liquidity should not affect corporate investment. This

is consistent with the conclusion in Oura (2008) that upgrading the financial system wouldcontribute to higher corporate investment. Most importantly, the results in the tables imply

that to stimulate investment in India, it would be critical to raise profitability. Thus, the next

question is, what would affect profitability?

7 Using an alternative measure of liquidity (e.g., current ratio (liquidity assets to short-term liability ratio)) doesnot change the results.

8 Appendix A conducts a robustness check, using an alternative data set (Thomson Reuters Worldscope).

9 For example, for capital-intensive manufacturing firms or smaller firms, liquidity might be more important ininvestment decision making.


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Table 2. Estimation of Investment Function 1/

OLS FE FD FD+IV 2/

(fixed

effect

estimator)

(first diff

method)

profitabilityq 0.024*** 0.040*** 0.028*** 0.060*** 0.040***

(0.0025) (0.0033) (0.0040) (0.015) (0.0068)

alternative q 3/ 0.0013

(0.0012)

liquidity 0.016*** 0.035*** 0.050*** 0.087*** 0.055*** 0.062***

(0.0020) (0.0023) (0.0042) (0.028) (0.014) (0.014)

leverage -0.035*** -0.21*** -0.30*** -0.28*** -0.16** -0.26***

(0.0087) (0.014) (0.027) (0.095) (0.073) (0.068)

stock price volatility -0.00090*** -0.00074** -0.000029 0.00071 -0.0053 -0.0052*

(0.00032) (0.00035) (0.00033) (0.00050) (0.0035) (0.0031)

lag of i/k 0.42*** 0.22*** -0.23*** 0.38*** 0.35*** 0.36***

(0.011) (0.0091) (0.012) (0.029) (0.023) (0.022)

Num of observations 12306 12306 8909 6686 8909 8909

Source: CMIE Prowess

1/ *** p


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Figure 2. Determinants of Corporate Investment

In India, profitability measured by Tobins q and ROA have not returned to pre-crisis levels.

0.00

0.50

1.00

1.50

2.00

2.50

3.00

0.00

0.50

1.00

1.50

2.00

2.50

3.00

FY2001 FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010

Ind ia B razil China Rus si a ASEAN4

Median Tobin's q of Nonfinancial Sector

Source: IMF Corporate Vuln erability database

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.00

0.02

0.04

0.06

0.08

0.10

0.12



Median Return on Assets of Nonfinancial Sector

Source: IMF Corporate Vulnerability database

Corporate liquidity in India measured either by the currentratio

or the interest coverage ratio is somewhat low.

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00



Median Current Ratio of Nonfinancial Sector 1/

Source: IMF Corporate Vulnerability database

1/ Current ratio is defined as liquid assets divided by short-term liabilities.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0



Interest Coverage Ratio of Nonfinancial Sector 1/

Source: IMF Corpor ate Vulnerability database

1/ Interest coverage ratio is defined as interest payments divided by earnings

before interest and taxes.

Leverage is on the high side and its increase is more pronounced in relation to cashinflows.

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40



Median Debt to Assets Ratio of Nonfinancial Sector


0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0



Median Debt to Cash Flow Ratio of Nonfinancial Sector



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India has substantial room for improving its business environment to enhance

corporate profitability.

In 2011, the World Bank ranked India 132nd of 183 countries in the world (up from 139 thin 2010) in terms of ease of doing business (top left chart of Figure 3). Indias ranking

reflects relatively high costs of doing business. For example, in starting a business, Indiais ranked at 166th

, while in registering property it is rated at 97th

. In enforcing contracts,

India is ranked at the second lowest (182nd

), with its costs amounting to nearly 40 percentof claims.

The OECDs product market regulation (PMR) indicators show that PMR, in particularbarriers to entrepreneurship, is restrictive in India, not only by advanced economy

standards, but also by emerging economy standards (middle left chart of Figure 3).10There is considerable room for relaxing employment protection. Indeed, Indiancorporates cite labor regulation as one of the key constraints on their business (World

Bank, 2012).

According to the World Economic Forum, Indias headline global competitiveness fell to56

thplace in 2011 from 49

thin 2009, reflecting weakening institutions (e.g., transparency

of government decision making) and relatively slow pace of infrastructure improvement

(bottom left chart of Figure 3). Among sub-indexes, the ranking in institutions has shown

a noticeable decline from 34th

in 2006 to 69th

in 2011. Note that Indias headline globalcompetitiveness ranking (56

thin 2009) is higher than the ranking measured by the World

Banks doing business indicators. This is because in measuring headline global

competitiveness, the World Economic Forum also incorporates indicators such as marketsize and financial development, where India performs well.

These rankings and indicators underscore the point that India could enhance corporate sector

profitability by reducing doing business costs, reforming regulation, improving institutions,and developing infrastructure. The impact of regulation reform on corporate profitability may

be ambiguous as regulation could also give rents to existing firms. However, there isempirical evidence that relaxing regulation has a positive impact on productivity (e.g.,

Conway, Herd, and Chalaux, 2008), which presumably benefits profitability.

10 PMR is calculated based on objective indicators related to product market regulations. For details about the

methodology to calculate PMR, see Conway, Janod, and Nicoletti (2005).


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Figure 3. Business Environment Indices

Indias rankings in terms of ease of doing business havestayed around 120140

thin the world

and India lags particularly in starting a business andenforcing contracts.

139132

0

20

40

60

80

100

120

140

160

0

20

40

60

80

100

120

140

160

2006 2007 2008 2009 2010 2011

Indi a Brazi l China Russia South Af ri ca

Headline Doing Business Rankings

Source: World Bank

0

20

40

60

80

100

120

140

160

180

200

0

20

40

60

80

100

120

140

160

180

200

Starting a

Business

Registering

Property

Paying Taxes Trading

Across

Borders

Enforcing

Contracts

In dia Br azil Chi na Russi a Sou th Afri ca

Rankings of Doing Business Indicators, 2011

Source: World Bank Product market regulation in India remains restrictive and there is room for relaxing employment protection.

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

China Russia India Indonesia Brazil OECD

average

Barriers to entrepreneurship Barriers to trade and investment

OECD Product Market Regulation Indicators, 2008

Source: OECD

0

0.5

1

1.5

2

2.5

3

3.5

0

0.5

1

1.5

2

2.5

3

3.5

Indonesia China India Brazil OECD

average

Russia

OECD Employment Protection Legislation Indicator, 2008

Source: OECD

In India, institutions have been weakening in recent years while infrastructure has remained weak.

4.5

4.34.2

4.2

4.0

3.8

3.53.4 3.4

3.5

3.5

3.6

2.5

3.0

3.5

4.0

4.5

5.0

2.5

3

3.5

4

4.5

5

2006 2007 2008 2009 2010 2011

Institutions

Infrastructure

India: Global Competitiveness Indexes

Source: Global Competitiveness Report (World Economic Forum)

1/ Rated between 1 and 7 (7 i s the highest).

0

1

2

3

4

5

6

0

1

2

3

4

5

6

Infrastructure Institutions Goods market

efficiency

Labor market

efficiency

Financial

market

development

India Brazil China Russia South Africa

Global Competitiveness Indexes, 2011 1/

Source: Global Competitiveness Report (World Economic Forum)

1/ Rated between 1 and 7 (7 is the highest).


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Large differences in the business environment exist within India. The World Bank has

reported doing business indicators across Indian cities three times in 2005, 2007, and 2009(see the Appendix B for main indicators and cities covered). Some of the indicators, such as

the costs of registering property and costs to export, vary significantly across cities (top two

charts of Figure 4). Restrictiveness of certain regulations, which states have the power to

control, is also very heterogeneous within India. For example, the OECDs product marketregulation indicator shows noticeable differences across states (bottom left chart of Figure 4).

While there are some business-environment-related indicators that do not vary much withinIndia (e.g., corporate tax rate, employment regulation), overall, the business environment is

very heterogeneous, suggesting that many cities and states in India can learn from the best

performers.

Figure 4. Variability of Business Environment within India

0

5

10

15

20

25

30

0

5

10

15

20

25

30

India: Costs of Registering Property (% of property value)

Source: Doing Business in Indi a in 2009 (World Bank)

0

200

400

600

800

1000

1200

1400

0

200

400

600

800

1000

1200

1400

India: Costs to Export, excluding tariffs (US$ per container)

Source: Doing Business in India in 2009 (World Bank)

1

1.2

1.4

1.6

1.8

2

2.2

2.4

2.6

2.8

1

1.2

1.4

1.6

1.8

2

2.2

2.4

2.62.8

Goa

Haryana

De

lhi

Ma

harash

tra

Tam

ilNadu

Pun

jab

Uttarancha

l

Karna

taka

Jhark

han

d

Ma

dhya

Pra

desh

Uttar

Pra

desh

An

dhra

Pra

des

h

Himacha

lPra

desh

Bihar

Kera

la

Assam

Ra

jast

han

Chha

ttisgarh

Orissa

Gu

jara

t

West

Benga

l

Source: Conwa, Herd, and Chalaux (2008).

India: OECD Product Market Regulation Indicator

60

65

70

75

60

65

70

75

India: Total Corporate Tax Rate (% profit)

Source: Doing Business in India in 2009 (World Bank)

The variability of the business environment within India allows us to explore the impact

of the business environment on profitability, using firm-level micro panel data.Specifically, this paper estimates the following equation, exploiting the variability of the

World Banks doing business indicators across Indian cities:

profitabilityj,t= a1 doing business indicatorsj,t+ a2 infrastructure proxyj,t+ control vars + j,t,


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wherej denotes firms , tdenotes years, control variables include time dummies and other

controls (leverage and liquidity).11 Only doing business indicators that vary enough acrosscities and that are reported in all three surveys (2005, 2007 and 2009) are included in the

regressions.12

As infrastructure proxy, I use phone density (percentage of telephone

connections, including cell phone connections). The phone density may also capture the

direct positive impact of phone access on profitability, which Jensen (2007) found amongfishermen. One may also want to include in the panel regression the OECDs product market

regulation indicator, which varies enough within India (bottom left chart of Figure 4), but this

is not feasible as the indicator is available across states only once. The error term j,tcontainsunobservable firm-specific factors, which may be correlated with independent variables. Toavoid a bias due to this correlation, this paper estimates the equation by either taking first

differences or using the fixed effects estimator. The regression uses the same micro panel

data set as used for estimating the investment function above (Prowess).

The results generally support the hypothesis that higher business costs reduce

profitability. Table 4 shows that costs of starting business, registering property, andenforcing contracts have the expected negative signs (except for a few cases) and are

significant in many cases.

Table 4. Regression of Profitability 1/

FD FE FD FE FD FE FD FE

(first dif) (fixed effectestimator)




Exporters

only

Exporters

only

Exporters

only

Exporters

only

costs of starting bus iness -0.0030 -0.0035 -0.029** -0.034*** -0.022 -0.023 -0.33*** -0.30***

(0.0028) (0.0024) (0.013) (0.011) (0.020) (0.021) (0.094) (0.096)

costs of registering property -0.0099 -0.023** -0.0042 0.0019 -0.094 -0.21** 0.22 0.24(0.013) (0.011) (0.034) (0.030) (0.094) (0.10) (0.25) (0.25)

costs o f enforcing contracts -0.0087* -0.0053 -0.028 -0.015 -0.12*** -0.080** -0.18 -0.21

(0.0051) (0.0041) (0.018) (0.017) (0.040) (0.037) (0.14) (0.15)

time to export -0.0090 -0.0047 -0.053 -0.060

(0.0072) (0.0069) (0.052) (0.060)

costs to export -0.00097 -0.00051 -0.0084* -0.0079

(0.00063) (0.00068) (0.0046) (0.0060)

phone density -0.0022 -0.00063 -0.0083* -0.0028 -0.033** -0.027* -0.077* -0.088*

(0.0017) ( 0.0016) ( 0.0048) ( 0.0053) ( 0.014) (0.015) (0.040) ( 0.046)

Num of observations 2173 3552 970 1888 2049 3147 932 1688

Source: CMIE Prowess

1/ *** p


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manufacturing productivity (e.g., Mohommad, 2010), further work is required to reach a

clearer conclusion about the relevance of infrastructure for corporate profitability.

The results imply that improving the business environment could boost corporate

investment substantially. The estimated coefficients in Table 2 and in columns 14 of Table

4 mean that reducing the average of each cost of doing business to the lowest among Indian

cities surveyed in 2009 could boost aggregate demand by to 1 percent of GDP, by raisingcorporate investment by 3 to 13 percent of GDP (Table 5). Of the various business costs,

lowering the average costs to export is estimated to be the most effective and could increase

GDP by 0.1 to 0.6 percent. Reducing the average of each of the other costs to the lowest

could raise GDP by 0.03 to 0.4 percent each. These results should be interpreted withcaution, as just cutting the costs included in the staff analysis may not be enough to produce

the growth effects reported in Table 5. This is because the costs of doing business are

correlated with other business-environment-related factors (e.g., product market regulation,education, skills) and the staffs estimates may have picked up the effects of such omitted

factors.

Table 5. Estimated Aggregate Impact of Reducing Costs of Doing Business

Total change in aggregate corporate

investment (in percent)3.1 - 13.5

Costs of starting business 0.6 - 1.8

Costs of registering property 0.3 - 1.9

Costs of enforcing contracts 1.0 - 4.0

Costs to export 1.2 - 5.8

Total direct demand impact on GDP

(in percent of GDP) 0.3 - 1.5

Costs of starting business 0.1 - 0.2

Costs of registering property 0.0 - 0.2

Costs of enforcing contracts 0.1 - 0.4

Costs to export 0.1 - 0.6

Reducing the Average

of Each Cost to Lowest

IV. POLICY ISSUES AND CONCLUSIONS

This paper argues that both macroeconomic factors and the business environment

affect corporate investment.

The analysis of macro data suggests that high and volatile inflation, and heightenedglobal uncertainty may have dampened corporate investment. While monetary easing

since the global financial crisis provided important support for corporate investment, the

monetary tightening since early 2010 may have started hurting corporate investment atthe margin. The main policy implication of these results is that lowering and stabilizing

inflation is critical for sustained investment growth.


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The analysis of micro panel data implies that to stimulate corporate investment,improving the business environment is essential. India has considerable room to improveits business environment. Specifically, priority areas include cutting various costs of

doing business and improving financial access. There is also some evidence that

developing infrastructure, especially transport, could support corporate investment. Given

the substantial variability in these areas within the country, India can learn from itself.

Business-environment-related factors that are not tested in this paper can also be

important in stimulating corporate investment in India. The empirical analysis in this

paper was able to examine only factors that vary enough within India and whose data are

available for multiple years. However, there are many other factors that are likely to play animportant role in supporting corporate profitability and investment. Such factors include

stable provision of electricity, ease of land acquisition, less restrictive regulations in product

and labor markets, simpler administrative procedures, and higher quality education and skills.

In many of these areas, India falls behind other emerging economies.


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References

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APPENDIX A.REGRESSIONRESULTS USING ANALTERNATIVE DATA SET

As a robustness check, this appendix reports results of firm-level micro panel regression

using an alternative data set: Thomson Reuters Worldscope. Tables A.1 and A.2 confirm thatthe results are very similar to those reported in Tables 2 and 4. Based on the coefficients in

Tables A.1 and A.2, reducing the average of each cost of doing business to the lowest among

Indian cities is estimated to raise aggregate demand by to 1 percent of GDP, which is asimilar range to that estimated using Prowess (Table 5).

Table A.1. Estimation of Investment Function 1/

OLS FE FD FD+IV 2/

(fixed

effect

estimator)

(first diff

method)

profitability

q 0.015*** 0.033*** 0.025*** 0.047*** 0.032***

(0.0027) (0.0035) (0.0050) (0.012) (0.0079)

alternative q 3/ 0.0041***

(0.0011)

liquidity 0.018*** 0.040*** 0.045*** 0.067** 0.044** 0.041*

(0.0044) (0.0043) (0.0096) (0.028) (0.022) (0.021)

leverage -0. 082*** -0.29*** -0. 34*** -0.28* -0.25*** -0.26***

(0.0096) (0.019) (0.031) (0.14) (0.080) (0.078)

s tock pri ce volat il ity 0.00055** 0.00070 0.00062 0.0012 0.0063** 0.0077**

(0.00022) (0.00051) (0.00083) (0.0011) (0.0027) (0.0032)

lag of i/k 0.42*** 0.12*** -0.27*** 0.26*** 0.30*** 0.30***

(0.015) (0.014) (0.019) (0.046) (0.035) (0.035)

Num of observations 5516 5516 4031 2878 4031 4031

Source: Thomson Reuters Worldscope

1/ *** p


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APPENDIX B.DESCRIPTION OF SEMI-AGGREGATE DATA

The analysis of micro panel data uses both firm-level data (from CMIEs Prowess) and semi-

aggregate city- or state-level data. The semi-aggregate data are the doing business indicators,the phone density, the number of bank offices per square kilometer, the ratio of electricity

supply to demand.

Doing business indicators. The data are from the World Banks Doing Business surveys.Broadly speaking, the survey reports three sets of variables in each business activity: i)

number of administrative procedures; ii) time needed to finish all the procedures; and iii)costs.1 The main indicators reported for Indian cities in 2005, 2007, and 2009 are

summarized in Table B.1.

Table B.1. Main Indicators Reported by the World Bank Doing Business Survey2005 2007 2009

Starting business

Procedures (number)

Time (days)

Cost (% of income per capita)

Dealing with construction permits

Procedures (number)

Time (days)

Cost (% of income per capita)

Employment regulation

Rigidity of employment index

Cost of firing (weeks of wages)

Registering property

Procedures (number)

Time (days)

Cost (% of property value)

Paying taxes

Payments (number)

Time (hours)

Total tax rate (% of profit)

Trading across borders

Documents for export (number)

Time to export (days)

Cost to export ( US$ per container)

Enforcing contract

Procedures (number)

Time (days)

Cost (% of claim)

Closing business

Time (years)

Cost (% of estate)

1 For more details, see http://www.doingbusiness.org/data.


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The survey covered 9, 12, and 17 Indian cities in 2005, 2007, and 2009, respectively

(Table B.2).

Table B.2. Indian Cities Covered by the World Banks Doing Business Survey

2005 2007 2009Ahmedabad

Bengaluru

Bhubaneshwar

Chandigarh

Chennai

Gurgaon

Guwahati

Hyderabad

Indore

Jaipur

Kochi

Kolkata Lucknow

Ludhiana

Mumbai

New Delhi

Noida

Patna

Ranchi

Num of cities covered 9 12 17

Phone density. The data are from CEIC. The phone density is defined as the percentageof telephone connections, including cell phone connections. This is a state-level variable,unlike city-level doing business indicators (above). In other words, firms in the same

state take the same value.

Number of bank offices per square kilometer. These data are calculated by dividing thenumber of bank offices by the area of each state. The data on bank offices are from theReserve Bank of India, while those on state areas are from the Ministry of Statistics and

Programme Implementation.

Ratio of electricity supply to demand. The data are from CEIC. The variable is calculatedat the state level.